The trick with a bond ladder is to stagger maturities in such a way as to always have a bond coming due at a time you might need the money, but also so as to be able to roll over maturing bonds into new bonds at higher rates of interest. The following images show the how this works in practice. (Click on images to expand them.)

Until recently, one of the disadvantages of bond ladders was their lack of diversification. By holding few bonds, bond ladders carry the risk that a default or partial default of one of the bonds in the ladder could greatly impact overall investment returns. Also, creating bond ladders for smaller portfolios has always been a challenge, as individual bonds may require high minimum investments. In addition, small investors tend to get clobbered with high purchase fees, as no sellers are willing to sell very small allotments at a good price. All of these factors – concentrated company and sector risk, high trading costs and a lack of liquidity – combined to make ETF’S and mutual funds more attractive than bond ladders for individual investors.

Now, however, this issue has been solved by a new brand of ETF’s that is designed to mature at a specfic target date . Bonds in these ETF’s are never sold prior to maturity, and are selected to mature as close as possible to the target date. As such, their real returns tend to correlate very closely to those of an individual bond expiring at the same targeted expiration date. But unlike individual bonds, they can be purchased at very low cost through discount brokerages or a Registered Investment Advisor, and they provide a great reduction of risk through diversification.

New targeted date ETF’s are appearing daily, but a
current list already covers a wide spectrum of dates, ranging from 1 year to 9 years, and a choice of sectors, including corporates, tax free municipals and high yield (junk) bonds.